Treaty shopping

What it means

Treaty shopping is the abuse of double tax treaties by inserting a company in a third country between the payer and the real recipient solely to benefit from a more favourable treaty. The aim is typically to reduce withholding tax on dividends, interest or royalties.

For example, an investor from a country with which Slovakia has no treaty, or a treaty with a higher rate, sets up a holding company in a country with a favourable treaty and routes income through it. The holding has no real activity and simply passes the money on to the owner.

Several tools counter treaty shopping: the concept of the beneficial owner of income, the principal purpose test added to treaties through the Multilateral Instrument, and economic substance requirements. All stem from the BEPS project and the principle that treaty benefits belong only to genuine residents.

How it works in practice

A Slovak company paying income abroad may apply the reduced treaty rate only if it holds the recipient's certificate of tax residence and has reasonably checked that the recipient is the beneficial owner of the income. In case of doubt it is safer to withhold the full rate.

The principal purpose test means a treaty benefit can be denied if obtaining it was one of the main purposes of a structure or transaction. Companies should therefore be able to explain why a foreign entity exists, what functions it performs and what decisions are taken there.

In group structures it is wise to review regularly whether intermediate entities in different countries have sufficient substance and business rationale. Records of staff, offices and decision-making should exist on an ongoing basis, not appear only once a tax audit starts.

What to watch out for

If the tax authority denies the treaty benefit, the company that withheld at the lower rate must pay the difference with interest and penalties, even though the money has already left the country. The risk lies with the payer, not just the foreign recipient, so the payer should vet the recipient carefully.

Payments to countries that Slovakia regards as non-cooperative jurisdictions are subject to increased withholding tax and further restrictions. Such payments must be assessed separately and against the current list of countries.